What Are Financial Derivatives?
Financial derivatives are contracts whose value is derived from an underlying asset, such as stocks, bonds, commodities, or currencies. They allow investors to speculate on price movements or hedge against risks without owning the asset directly. In investing, derivatives provide leverage, enabling amplified returns or losses based on small market changes.
Key Types of Derivatives
The main types include futures, which are standardized contracts to buy or sell an asset at a future date and price; options, giving the right but not obligation to buy (call) or sell (put) an asset; swaps, exchanging cash flows like interest rates; and forwards, customized over-the-counter agreements similar to futures. Each serves distinct purposes in portfolio strategies.
Practical Example in Investing
Consider an investor holding Apple stock who fears a price drop. They buy a put option derivative, paying a premium for the right to sell shares at $150. If the stock falls to $130, they exercise the option to sell at $150, limiting losses. This hedges the portfolio without selling the shares, illustrating derivatives' risk mitigation in real-world scenarios.
Importance and Applications in Investing
Derivatives are crucial for risk management, speculation, and arbitrage in investing. They help diversify portfolios, protect against volatility, and access markets efficiently. However, their leverage amplifies risks, making them suitable for experienced investors. Understanding basics empowers better decision-making in volatile financial environments.